Early Retirement Cash Flow With The Roth IRA Conversion Ladder

Most people exploring financial independence and early retirement quickly arrive at a similar question: “How do I access the money I’m saving away between early retirement and traditional retirement age?” It’s one of the most common questions I see in the early retirement community and a very important one to understand the answer to if you decide to venture down your own path towards early retirement. With the large emphasis on utilizing tax-advantaged accounts such as 401k’s and IRA’s, it might appear that the money is locked away behind a large penalty until the age of 59 and a half!

One solution is to only utilize tax-advantaged accounts to hold money you won’t need to access until traditional retirement age, but this causes you to end up paying a lot more taxes over the course of your lifetime than is necessary. A more elegant (and profitable) solution is to utilize a strategy referred to as the Roth Conversion Ladder in order to access tax-deferred money before age 60 without paying any tax penalties.

Below, I’ll cover the basics of the Roth Conversion Ladder and walk through a hypothetical case study of a person who retired at 40 and lived off of their investments with all the details of how the money was invested and eventually withdrawn to live off of.

The Roth IRA Conversion Ladder

I couldn’t tell you who first discovered this IRA withdrawal strategy, but if you’ve read very much content on financial independence or early retirement, you’ve probably heard it mentioned before. The strategy allows someone who has a lot of money tied up in Traditional, tax-deferred retirement accounts to withdraw that money over time without penalty, even if they are well under the age of 59 and a half (when you can start withdrawing directly without penalty).

The ladder really only makes sense for an early retiree, as we’ll see below, because the primary action in the strategy is a taxable event which would stack on top of any earned income for the year. An early retiree with little to no earned income will have to pay very little taxes (if any!) on this conversion, whereas someone with full time employment would end up paying a lot more taxes (and in their marginal tax bracket or higher!) if they chose to follow this strategy while working.

Roth IRAs hold post-tax money which can be withdrawn completely tax free (gains and all) at age 59.5

Direct contributions to a Roth IRA can be withdrawn at any time without penalty (but not any gains)

Money in a Traditional IRA can be converted over to a Roth IRA at any time, but the converted amount is taxable income for the year of the conversion.

Money converted from a Traditional IRA to a Roth IRA can be withdrawn penalty free after 5 years (but not any gains)

With those 4 simple items in mind, here is the standard implementation of the Roth IRA Conversion Ladder:

Before retirement, have enough money accessible outside of tax-deferred accounts to cover 5 years of expenses.

This can come from standard brokerage accounts, savings accounts, previous direct Roth IRA contributions, or any other number of places.

Upon early retirement, roll existing 401k balances into a Traditional IRA (this is not a taxable event as you are simply moving from one tax-deferred account to another.

For each of the first 5 years, convert the amount of money you desire to live off of 5 years later (and pay taxes on the amount) while living off of the money you prepared in step 1.

For the 6th year up until age 59.5, once again convert the money you desire to live off of in 5 years (paying taxes on the amount), but now you can start withdrawing the conversions from 5 years prior to live off of!

After age 59.5, simple withdraw you necessary spending money directly from a combination of the Traditional and Roth IRAs.

There’s a few small optimizations that can be done within the 5 steps above to reduce taxes and save money, but that covers the basics.

Confused? That’s okay because I’ll now walk through an example all the way from college graduation to early retirement at age 40 and cover where all the money is coming from and going all the way up to age 65!

Our Hypothetical Savvy College Grad

For this example, we will use someone at a young age that is just starting their first job and decides to set themselves up for financial independence by age 40. In order to avoid continually saying hypothetical person, let’s give this person a name and go with Jordan. Jordan recently graduated college and landed an awesome job making more money than necessary for them to live a happy, fulfilled life and decides to put together a plan to achieve financial independence by 40 and live off investments instead of working a regular job. This plan involves maxing out the available retirement accounts (401k and Roth IRA), investing extra money in a standard brokerage account, and then utilizing a Roth IRA Conversion Ladder to access money between ages 40 and 60.

Luckily, Jordan is compensated quite well at his job for a new college grad and after maxing out the 401k contribution at $18,000 per year and paying taxes, Jordan is left with exactly $53,500 in post-tax money. Jordan is content with a life of spending $40,000 per year and is able to invest the additional $13,500 each year.

With a post-tax income of $53,500 on top of a $18,000 retirement contribution, this puts Jordan’s gross income just over $90k which is quite high for the average college grad. One thing to keep in mind though is that Jordan doesn’t get a single raise (other than inflation) all the way up to age 40 before leaving the job. In addition, Jordan decided to go it alone and never got married or took advantage of having a two-income household, so the numbers below are comparable to a married couple making a combined $90k except you’d be even better off with the various tax advantages of having two incomes instead of one. While the exact numbers might not be directly relatable to your own situation, the ideas and strategy remain the same for anyone saving ~45% of their household income.

The Cash Flow Overview

The chart below covers the balances in Jordan’s investment accounts all the way from his first paycheck at 23 up until age 65 (and don’t forget Jordan retired at age 40!). I’ll explain what’s going on in the chart below by breaking down Jordan’s life into 3 phases: Accumulation, Early Retirement, and Traditional Retirement

Chart Color Key:

Green = Investment Contributions (Accumulation Phase)

Blue = Roth IRA Conversion Ladder (Early Retirement Phase)

Red = Investment Withdraws for Annual Spending

Purple = Blue + Red

The Accumulation Phase

Jordan managed to find some great financial mentors before graduating college and decided to start heavily investing in his eventual freedom from the very first paycheck out of college. Luckily Jordan was able to start without any student debt, but there also weren’t any assets to speak of either. That puts Jordan at a starting point of $0 in net worth, but with steady investing it won’t take long to start building up those investment accounts.

Jordan withholds the maximum amount that a 401k plan allows for standard tax-deferred contributions at $18,000 and the employer even adds a $1,000 match on top. In addition to the 401k, Jordan decides to take advantage of contributing to a Roth IRA to save even more on eventual taxes. At a taxable income of ~$72,000, Traditional IRA contributions wouldn’t be able to be deducted from taxes (and would be a poor choice because of that), but Jordan can still take advantage of contributing directly to a Roth IRA to avoid paying taxes in the future on any gains. Jordan decides to contribute the max of $5,500 and still has $8,000 left over at the end of the year which is invested in a standard brokerage account.

Each year from age 23 to 40, Jordan manages to contribute $32,500 towards investments and manages to achieve a steady 7% growth year over year.

While the stock market has averaged ~7% real gains over a long period of time, this certainly wasn’t a steady 7% gain annually as the chart above shows. In the real world, the 7% average comes after many years of 15% growth, -30% falls, 0% movement, and everything in between, but with a diversified investment such as index funds, it’s certainly possible to ride the average over time. Just don’t get caught up checking the actual number too often, or you’ll drive yourself mad!

In the chart above, the cells highlighted in green show this annual $32.5k investment contributions and how they add up over time. By the age of 40, Jordan has over 1.1 million dollars across the three accounts! Keep in mind the actual amount invested was only $585,000 which means the steady 7% annual growth returned over half a million dollars in gains over 17 years!

At this point, Jordan is still content with annual spending of $40,000 and decides to leave full time work in order to pursue all of the different opportunities that freedom from the 40-hour workweek provides. Time for early retirement at the ripe age of 40!

The Early Retirement Phase

At this point, Jordan has $1.1 million spread over 3 different accounts:

$645,982 in a Traditional 401k account

$186,995 in a Roth IRA account ($99,000 of which are direct contributions)

$271,992 in a standard brokerage account

From age 40 onward, Jordan switches to more conservative investments and ends up getting exactly 4% gains for the rest of time. Luckily this approximately matches the amount needed for annual expenses which means the principal of the total investments will pretty much stay the same despite annual withdraws for living expenses.

Jordan will start the Roth IRA Conversion Ladder right away at age 41, but won’t be able to touch those conversions until age 46 because of the 5-year waiting period. Between the money in the standard brokerage account and the Roth IRA contributions, Jordan has enough money to cover more than 5 years of expenses. This means converting very specific amounts can result in very low or even $0 tax bills!

The first step to setting up a Roth IRA Conversion Ladder is to transfer all of the money from the 401k into a Traditional IRA, so Jordan does that right after retiring. Once that process is complete, it’s time to convert the first rung of the ladder!

At age 41, Jordan converts exactly $10,350 from the Traditional IRA to the Roth IRA to exactly match the total of the standard deduction and personal exemption which means the taxable income for this event in isolation is $0! In order to cover annual expenses, Jordan also has to withdraw $40,000 from the brokerage account which consists of ~$18,000 in capital gains. Capital gains are taxable income, but they follow a different set of tax %’s than standard income. In the case of total taxable income being in or below the 15% tax bracket, that tax rate is 0% and that happens to be exactly where Jordan falls. That’s $28,350 in income for the year ($10,350 conversion + $18k in capital gains) with a tax bill of $0!

For even more optimization, this would be a great opportunity to harvest some capital gains in order to avoid potentially paying taxes on them in the future. The 15% tax bracket goes up to $37,650 for a single filer, which means an additional $9,300 gains could be realized without causing any taxes owed for the year. I recommend the Mad Fientist’s post on the subject if you want to know more.

At age 42, Jordan knows that it will eventually be necessary to convert more than $10,350 at a time in order to cover annual expenses of $40,000 up until age 59.5, and therefore decides to calculate a conversion amount that will max out the 10% tax bracket. At the eventual higher conversions, Jordan will be well into the 15% bracket, so making some additional conversions at 10% could save money over the long run. Jordan determines that number to be $19,625 ($10,350 deduction/exemption + $9,275 which is the top of the 10% bracket).

In order to cover the small tax bill of $928, Jordan takes an additional $1,000 out of the brokerage account. While this causes additional taxable income in the form of long term capital gains, the total taxable income is below the standard 15% bracket, so the tax rate on these gains is still 0%.

Jordan continues with the $19,625 IRA conversion up until age 45 when the numbers show that the brokerage account and accessible Roth IRA contributions will start to dip pretty low. At this point, Jordan decides to convert the full amount that will be needed to cover expenses in 5 years while still having a large accessible buffer of money.

Jordan knows that $40,000 is still the amount of spending needed in 5 years, but because converting money from a Traditional IRA to a Roth IRA is a taxable event, the actual amount converted will need to be a little higher. After reverse-engineering how much to convert in order to achieve $40,000 post-tax, Jordan settles on converting $45,000 per year. With a $45,000 conversion, the taxable income will reduce to $34,650 (thanks to the standard deduction and personal exemption), and the total federal tax bill for each year will end up at ~$4,734.

Keep in mind that Jordan is still withdrawing a large amount from the brokerage account to cover living expenses, about half of which is long term gains. As the $45k taxable income from the IRA conversion almost maxes out the 15% tax bracket by itself, the majority of the long term gains withdrawn (~$22,000 worth) will be taxed at 15%. So with the $40,000 to cover living expenses, ~$4,734 to cover taxes on the conversion, and ~$3,200 for the capital gains taxes, Jordan calculates that withdrawing $48,000 will be just the right amount.

Note: While all of the numbers shown are annual, any of the withdrawals can happen at any point during the year and broken up however is convenient. For example, Jordan might decide to withdraw $4,000 per month from the brokerage account instead of all $48,000 as a lump sum. The IRA conversion should probably be done all at once for simplicity, but there is a lot of flexibility for exactly when any withdrawals are taken within a given year.

At age 48, the money in the brokerage account finally runs out and Jordan begins taking money from the large pool of accessible Roth IRA contributions that have built up. Keep in mind that $45,000 is still being converted from the Traditional IRA and added to the Roth IRA in the same year that older contributions are being withdrawn. This is represented by the color purple in the chart above.

At age 49, Jordan converts and withdraws exactly $45,000 from the Roth IRA causing a net contribution of $0. That doesn’t stop the money that’s already in there from growing though!

At age 50, Jordan is less than 10 years away from the magic age of 59.5 where money can directly be withdrawn from the Traditional IRA without penalty (and all Roth IRA money, not just the contributions, can be withdrawn tax and penalty free). Converting money as a part of the Roth IRA Ladder isn’t necessary for those final 5 years, so Jordan chooses to simply convert exactly the amount needed for those 5 years, $40,000. That $40,000 conversion comes with a ~$4,000 tax bill, so the net contribution to the Roth IRA is -$4,000 after taking out the required $44k to cover expenses and taxes for the year.

From ages 55-59, Jordan simply withdraws the amount needed for annual expenses from the large pool of accessible Roth IRA conversions/contributions.

The Traditional Retirement Phase

Now that Jordan is at the traditional retirement age as dictated by the direct withdrawal rules of the account, everything becomes much easier.

At age 60, Jordan has full access to both the Traditional IRA and the Roth IRA and can choose how to split the withdrawals from as desired. (This is additional opportunity to get creative with the exact withdrawal amount and fit within the best tax bracket for maximal optimization.)

Ages 66 and beyond were left out because there are a few additional complications around that age that kick in such as Required Minimum Distributions (or RMDs) and Social Security payments (Jordan worked for 18 years and should be owed something) which impact tax implications significantly. At this point I’m confident Jordan will figure out a way to make it all work. Even after 25 years of not working and $40k per year expenses, there is more money in the accounts now than Jordan started with!

A Note About Traditional Vs. Roth Accounts

Traditional versus Roth accounts is an endless debate in the world of personal finance, but I would say it’s pretty hard to find a situation where an early retiree shouldn’t be taking advantage of Traditional accounts while working. The example above really laid out the power of having tax-deferred accounts available during the Early Retirement phase. From ages 41-54, Jordan converted almost half a million dollars ($494,225 to be exact) and only paid $46,479 in federal income tax!

All of the money placed into the Traditional 401k account (that was eventually rolled into a Traditional IRA) was deducted from the 25% tax bracket and withdrawn at a rate below 10%. That’s over 15% savings in taxes, or ~$2,700 per working year in bonus money for being tax savvy during the accumulation and early retirement phases. These savings would be lost completely if Jordan chose to use a Roth 401k or standard brokerage account instead of the Traditional 401k!

Additional Optimizations and Options

While I covered an early retirement strategy from start to finish with all a lot of tips and tricks to optimize taxes, there are many others that were left out. If Jordan had access to an HSA, there would be an additional $3,350 available in tax-deferral or avoidance per working year. The exact conversion strategy I laid out was more than sufficient to get from early retirement to traditional retirement age, but there is still plenty of room for small optimizations in the exact amounts converted each year.

And don’t forget that Jordan did it all alone from start to finish, adding a significant other on the same financial page (married or not) to split expenses with can make for significant savings, not to mention that adding children to the mix comes with lots of tax benefits (and also cost money and come with a lot of responsibility, so I wouldn’t start breeding just to save on taxes!).

It’s also important to note that an alternative to utilizing a Roth Conversion Ladder is something called a 72t distribution. This allows you to pull money directly out of the Traditional accounts without penalty, but comes with some strict guidelines and heavy penalties if not followed correctly. The 72t distribution certainly remains a good backup option in the event that IRA rules change at some point in the future.

Every person’s financial situation is different, but I’m a strong believer that almost anyone can achieve financial independence (and retire early if they choose) with conscious spending and consistent saving over time. The earlier you start the better thanks to compound interest, so don’t delay making that first step!

Quick sanity check as I’m wrestling with my own numbers. If you use an inflation adjusted growth rate estimate for your portfolio, will that account for the year-over-year increase in contribution limits to 401k, HSA, etc.?

All of the numbers I worked though above and in the excel sheet are in today’s dollars. That means the contribution limits for each year will also take into account inflation adjustments automatically. It’s obviously not a 100% perfect result because the limits only go up in $500 increments rather than a smooth curve, but the calculations should remain pretty much the same.

For example, let’s look at the $5,500 limit today on the IRA contribution. If you need $6,000 to purchase the same stuff in 2020 that $5,500 gets you today, then inflation says that the IRA limit should be adjusted upwards to $6,000. Even though the limit in 2020 dollars has increased, it’s still an effective $5,500 in today’s (2016) dollars.

Overall, I find it best to not worry about inflation when predicting outwards and just make sure any gains you forecast are already inflation adjusted. In the case of contibution limits, everything will be fine keeping them at their current levels and using today’s dollars.